AOL: Still a Fantasy Stock

At current levels, the media giant may look tempting. But investors who see a bargain are living with the Hobbits

AOL Time Warner's (AOL ) new hit movie Lord of the Rings: The Fellowship of the Ring presents a strange, fantastical world. It's lit one moment by fireworks; the next, smoke and mist obscure every vista. This atmosphere, at once intriguing and spooky, turns out to be very much like what awaits anyone who dares to tour AOL's financial world, a land full of skyrocketing cash flows and unfathomable write-offs. You can read AOL's financial statements, as I have recently, and come away with as clear a view of reality as you would get by following Frodo Baggins through Middle Earth.

This is a pity, because shares in AOL, trading recently near $32, probably look tempting to many investors. I warned against them a year ago after AOL completed its deal for Time Warner amid enough hype to make a Hollywood publicist blush. But they're a lot cheaper today, down from a peak in May of more than $58. As they kept falling, I began to wonder: Are they a bargain?

Don't bet on it. It's not the litany of recent AOL worries, from sluggish advertising sales to slower growth in online subscribers to the untimely decampment of CEO Gerald Levin, that leaves me skeptical. It's not even the $40 billion to $60 billion asset write-down AOL is taking to concede how wildly overpriced its merger with Time Warner proved. On the contrary, these concerns seem to have been duly noted by investors as AOL shares edged their way down. What stumps me about AOL is the proposition that there's some magic in this media monolith that should compel investors to take on the risk implied by its premium price.

To CEO-in-waiting Richard Parsons, a rich market valuation makes sense given the company's strategic position. "AOL Time Warner is the most exciting company in the world," he told Wall Street in a Jan. 7 presentation, with "the potential to be the most valuable." One day, maybe. Today, though, it's worth wondering if AOL deserves a market value of $146 billion, No. 16 on planet Earth, just behind Cisco Systems (CSCO ).

A clearer picture will emerge Jan. 30, when the company is set to release detailed results for 2001. AOL already has indicated that the year brought 5% growth in revenue, to $38 billion. "EBITDA"--earnings before interest, taxes, depreciation and amortization, a measure that AOL and other media companies focus investors on--grew 18%, to nearly $10 billion. Amid recession and slumping ad sales, that's healthy. Yet that also implies a price-to-EBITDA multiple of 15, when AOL itself sees EBITDA growth slowing this year to 8% to 12%. Next to shares of rival Walt Disney, trading recently at an EBITDA multiple below 10, AOL stock hardly screams "Buy me!"

AOL measures success internally not just by EBITDA but also by "free cash flow"--cash from operations after capital spending and dividends. In 2001, not counting a raft of items it considers unusual, the company estimates free cash flow hit $3 billion. That means the market is valuing AOL shares at 49 times free cash flow.

To see how that compares, I searched Morningstar's database for companies with positive free cash flows over the most recent 12 months and market values of at least $100 billion. Various accounting treatments can make this a bit hazardous. Yet it is also instructive. Besides AOL, I found 21 others, from market-cap leader General Electric (GE ) down to Philip Morris (MO ). Only four--Intel (INTC ), Vodafone (VOD ), Wal-Mart (WMT ), and SBC Communications (SBC )--were trading at multiples of free cash flow higher than AOL's. Many big growth stocks, including Microsoft (MSFT ) (29) and Merck (MRK ) (24), were going a lot cheaper.

In the Rings movie, a world-weary hobbit at one point complains: "I'm feeling like butter, scraped over too much bread." If AOL shares tempt you, just substitute free cash flow for butter and the stock's price for bread.

By Robert Barker

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